The Curious Thing mREITs Are Spending Millions a Year On

Since the massive double-digit dividend yields are Annaly Capital Management (NYSE: NLY) and American Capital Agency's (NASDAQ: AGNC) appeal, it's essential to look into the costs that may be cutting into that yield.

Though, considering mREITs can avoid income taxes completely by paying out the majority of their taxable income to shareholders, it's hard to imagine taxes as the culprit. But from 2012 to 2013 Annaly and American Capital Agency paid roughly $62 million and $35 million in taxes, respectively -- so what's the deal?

Well, there are actually a number of situations in which REITs are subject to taxes. This includes: REIT subsidiaries, spill-back provisions, and retained earnings. Which makes the real question: is this something shareholder's should be concerned about?

1. Taxable REIT subsidiariesReceiving favorable tax treatment, as with most good things, comes with strings attached. To qualify as a REIT Annaly and American Capital Agency have to pass a series of "tests." This includes holding only certain types of assets and generating income in specific ways.

But by creating and owning a piece of a stand-alone business -- also referred to as a taxable REIT subsidiary (TRS) -- it provides mREITs with a loophole.

For instance, Annaly and American Capital Agency use hedging transactions to protect against rising interest rates and increasing borrowing costs. But since income earned from these transactions doesn't qualify under the "income test" it could jeopardize their REIT status. So, they delegate this task to their TRS.

Moreover, TRSs can earn fee income by providing services to other businesses -- another no-no for REITs to do directly.

Here's the catch: taxable REIT subsidiaries, as the name implies, are subject to the normal tax rate. And in 2013, Annaly paid roughly $8 million in income taxes for "income attributable to its TRSs."

Considering the tax paid for TRSs isn't particularly high, they are essential for conducting business, and create more value than they cost, investors shouldn't be worried about taxable REIT subsidiaries.

2. Spill-back provisionsIf Annaly or American Capital Agency fail to meet the minimum required distribution (dividend payment) in a given calendar year they aren't automatically disqualified as a REIT. Rather, they are allowed a "spill-back provision." This allows mREITs to payout last year's taxable income this year, and still not be liable for income tax.

But the IRS doesn't extend such generosity for free. The penalty for late payment comes with a 4% "excise" tax. Between 2011 and 2013 American Capital Agency paid approximately $30 million in excise taxes.

There are a number of reasons why a company would pay late. For instance, American Capital Agency notes specifically that "cash" and "income" don't always match up perfectly and at the end of the a calendar year they may not have cash on hand to make the appropriate distribution -- and rather than borrow or sell assets to make the payout, they simply hold out and pay the excise tax.

Late payments on distributions is a bigger issue than taxes paid on TRSs. But holding an investment rather than selling it early to make distributions could more than pay for the tax. With that said, I don't see this as a huge issue either.

3. Retained earningsWhile Annaly and American Capital Agency, currently, shoot to distribute 100% of taxable income, if they paid the minimum 90% they would pay the normal tax rate on the retained 10%.

But for Annaly, specifically, this hasn't always been the case. Back in the late 1980's -- in an attempt to control excessive executive compensation -- the IRS created "section 162(m)." Which states that only $1 million in key executive compensation, not including some incentive pay, would be tax deductible.

Well, considering Annaly executives are paid well, well, above $1 million it shouldn't be surprising that between 2011 and 2012 Annaly paid more than $60 million in income tax on retained earnings for executive compensation.

The good news, I guess, is that with Annaly externalizing it's management in 2013 we won't have to worry about the retained earnings tax.

The last word Ultimately, Annaly and American Capital Agency pay significantly less in income taxes than non-REIT companies of similar size. So, despite the million they have paid, and the million yet to come, I believe these are moves that are necessary for the businesses to be successful, rather than being something to worry about.

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